Feb. 3 — The Securities and Exchange Commission proposes exempting small companies and startups raising capital under Regulation A from state blue sky laws.
While the business community says the move will tear down a needless obstacle to capital building and job creation, state regulators say they are “dismayed” and “shocked” by what they consider to be an anti-shareholder plan.
“We urge the Commission to remove these provisions from the rule,” William Galvin, Secretary of the Commonwealth of Massachusetts, said in a Dec. 18, 2013, letter to the SEC.
The SEC is accepting comment letters from the public on its proposed Section 3(b)(2) of the Securities Act of 1933, which would amend Regulation A, until March 24.
The amendment is referred to as Regulation A-Plus, and it is designed to make it easier for smaller companies to raise capital, Katherine K. DeLuca, an associate in the Richmond office of McGuireWoods LLP, told Bloomberg BNA Jan. 30.
To make it easier, Regulation A-Plus would preempt state laws that regulate the offering of securities made within their borders.
The SEC has said that without broad federal preemption, state blue sky laws would remain an obstacle to Regulation A's popularity, DeLuca said.
As proposed in December, Regulation A-Plus will serve as a useful alternative to Regulation D in the eyes of many issuers seeking capital. “They will provide a meaningful choice to companies depending on their needs and goals,” DeLuca said.
Congress mandated the changes to Regulation A as part of the Jumpstart Our Business Startups Act of 2012. It directed the SEC to adopt rules exempting offerings of up to $50 million in securities annually from the registration requirements of the Securities Act of 1933. Currently, Regulation A exempts offerings of up to $5 million over a rolling 12-month period.
The SEC's Regulation A-Plus not only addresses the money threshold, but also includes issuer eligibility rules, content and filing requirements for offering statements, and ongoing reporting requirements for issuers.
David N. Feldman, an attorney and partner in the New York office of Richardson & Patel LLP, told the SEC in a Jan. 15 comment letter that one main reason Regulation A has almost never been used was the “delay, cost and uncertainty” of divergent state review of offerings caused by state blue sky laws.
In some cases, blue sky laws conflict with SEC disclosure standards and are based on arbitrary merit standards, he said.
“The preemption (of state securities regulation) will create a major incentive for companies seeking a public trading stock to utilize Regulation A-Plus, and the states can continue to play a key role in enforcement and regulation of market intermediaries,” he wrote.
Regulation A has not been the most popular route for companies looking to raise capital. The SEC reported only 19 Regulation A offerings, involving $73 million, from 2009 to 2012, DeLuca said. In contrast, the SEC reported 27,500 offerings under Regulation D, amounting to $25 billion, and 373 registered offerings, totaling $840 million dollars, from 2009 to 2012, she added.
“Regulation A offers some desirable features for issuers but also has some significant limitations that would explain its recent unpopularity,” DeLuca said during a Jan. 28 McGuireWoods webcast, “SEC Compliance and Disclosure Update.” “One of its biggest is its size limitation” of $5 million.
Unlike Regulation D offerings, Regulation A does not limit who may make purchases, and the securities sold are not restricted, which means they are freely tradable.
Regulation A also does not prohibit general solicitation or advertising, and “issuers are allowed to test the waters in order to gauge investor interest before the offering is launched,” she said.
“We urge the Commission to remove these provisions from the rule.”William Galvin Secretary, Commonwealth of Massachusetts
Regulation A has always been intended to serve as an easy means for small companies to raise limited capital, but it has not successfully served that role, especially in recent years, she said.
As part of Regulation A-Plus, the offering threshold was raised to $50 million from $5 million over a rolling 12-month period. Every two years the SEC must review that limit and increase it if appropriate. If the SEC decides not to increase the offering limit, it must explain to Congress why. The first review is to be completed by April 5 of this year.
The JOBS Act also preserves some of Regulation A's most desirable features, DeLuca said. The statute dictates that Regulation A offerings will continue to be public offerings, that the securities sold are not restricted and that issuers are allowed to test the waters, she said.
The statute adds a new requirement that Regulation A issuers must file annually audited financial statements with the SEC. Otherwise, the JOBS Act left it to the SEC to mandate the other terms and conditions of Regulation A through its rulemaking authority.
“The SEC took aggressive steps to make Regulation A a truly workable option for issuers,” DeLuca said.
Regulation A-Plus creates two tiers of offerings. Tier 1 resembles current Regulation A, but can include up to $1.5 million in securities for the account of selling security holders. Tier 2 allows for offerings up to $50 million over a 12-month period
For Tier 2 offerings, the proposed rules include several new requirements designed to protect those who purchase shares in those larger offerings. They include audited financial statements, which will be required of Tier 2 initial filings.
In the past, issuers did not have to provide audited financial statements unless they already had them prepared for other reasons. This will remain the case for Tier 1 offerings.
The proposal also includes a cap on the amount of securities an investor may purchase through a Tier 2 offering. The cap would be set at 10 percent of the greater of the investor's annual income or net worth.
The rules also would allow the issuer to rely on investor representation of compliance, unless issuer has reason to believe investor's representations are false, DeLuca said.
Tier 2 offerings will be subject to new, ongoing reporting obligations, including an annual Form 1-K, which asks for much of the same information as in a 10-K.
Issuers also will need to file an interim report on Form 1-SA, which reports on the issuer's first six months of its first reporting year, DeLuca said. It is much like a 10-Q. In addition, issuers will be required to file Form 1-Us, which will have a four-day deadlines and serve much the same purpose of an 8-K.
These reporting requirements will remain in place for at least one year after the offering is qualified and for as long as the offering is ongoing. Both tiers must report on the completion of the offering.
“The new reporting requirements in Tier II offerings allow investors to have regular and current information on important developments while easing some of the burdens of full reporting.”David N. Feldman Partner, Richardson & Patel LLP
“The SEC points to all these protections in order to justify preempting state blue sky laws,” DeLuca said. “Under the current rules, all Regulation A offerings are subject to state blue sky laws.”
In addition to going through the federal filing and review process, which took an average of 228 days, Regulation A issuers were subject to review in any state in which they wanted to offer securities, DeLuca said.
All states conduct their own disclosure review and unlike at the federal level, states also analyze the fairness of the offering to investors and compare it to their own merit standards, DeLuca said.
Issuers must address the state's merit and disclosure concerns before the offering may proceed, she said. That is time-consuming and expensive, “as it leads to more and more legal and accounting fees,” she said.
The Regulation A-Plus proposal exempts all Tier 1 and Tier 2 offers and all Tier 2 purchases from blue sky laws by expanding the definition of “qualified purchaser,” DeLuca said.
The SEC proposed that the term “qualified purchaser” be defined to mean an accredited investor as defined in Rule 501(a) of Regulation D, saying, “We believe that it is appropriate to equate qualified purchasers with accredited investors because the regulatory and legislative history of both terms are based upon similar notions of the financial sophistication of investors and accredited investor is a long-standing concept familiar to the small business community and other industry participants.”
Mike Liles Jr., a shareholder and member of the corporate finance practice group of Karr Tuttle Campbell of Seattle, Wash., expressed criticism of this use of “qualified purchaser” in a Jan. 17 comment letter to the SEC.
Offerings under Section 3(b) are aimed at unsophisticated retail investors, so more limiting language is needed, he said. The lack of any language akin to “sophisticated investors, capable of protecting themselves” in the proposed definition is “unexpected and questionable,” he said.
“In effect, the use of the definition of ‘qualified purchaser' merely as a tool for effecting preemption of state regulation without providing any substantive element of investor protection, is jarring in this context and would not appear to be what Congress intended in enacting Section 401(b) of the JOBS Act,” he wrote.
Liles warns that if the “qualified purchaser” language is kept and adopted, as is, it might not withstand legal challenge.
Such a possibility “might discourage efforts by regional investment bankers from committing the significant resources required to properly service small business public offerings until the Section 3(b) Proposal's ability to withstand a challenge has been definitively decided by the courts,” he said.
The North American Securities Administrators Association, an organization that advocates for pro-investor policies, is fighting the SEC's blue sky law preemption provision.
Andrea Seidt, the association's president, said in a message on the NASAA website that state oversight of Regulation A offerings is “essential” given the risky nature of investments in startups.
“However, we recognize the need to change some of our longstanding policies,” she wrote.
The NASAA is consulting with a task force of the American Bar Association to develop a uniform review protocol for states to adopt, she said. Under the new protocol, lead examiners would handle the review of a registration application and work with the issuer to try to remedy any deficiencies within a set time frame.
The organization is also planning to build an electronic filing platform that companies and states would use, Seidt said.
Calls to NASAA for comment were not returned.
The lower-tier over-the-counter trading markets for stocks, such as the Pink Sheets Market and the OTCBB, which list stocks of small public companies, are notorious for providing insufficient information to the public and for fraudulent and abusive practices, Secretary Galvin said in his letter to the SEC.
Rule 506 offerings, under Regulation D, already give issuers a way to raise unlimited amounts of money with no substantive regulatory review at any level, and they are the No. 1 source of state enforcement complaints for fraud, Galvin said.
The plan to preempt state review for Regulation A offerings must be scrapped, Galvin said.
“The states have tackled preemption battles on many fronts, but never before have we found ourselves battling our federal counterpart,” Galvin said in his comment letter to the SEC. “Shame on the SEC for this anti-investor proposal. This is a step that puts small retail investors unacceptably at risk.”
Regulation A offerings are often local in character, he said.
“If that pattern continues, Regulation A-Plus offerings will also be sold substantially in the issuers' home states and in local-area markets,” he said. “For this reason alone, it is crucial for the states to have a role in overseeing these offerings in order to protect their citizens.”
The SEC's preemption provision “contravenes Congress' express intent on this issue,” he said.
“When the Regulation A-Plus legislation was under consideration, Congress considered, but ultimately rejected, language that would preempt state review of those offerings,” he added. “NASAA and the states tracked this legislation and successfully urged that state authority to review these offerings should be maintained.”
Even if the NASAA's new protocol for a multistate review process is developed, the preemption of state blue sky review is needed if Regulation A is to be successful, Feldman said in his letter.
“The new reporting requirements in Tier II offerings allow investors to have regular and current information on important developments while easing some of the burdens of full reporting,” he said. “In addition, audited financial statements meaningfully improve investor protection and confidence, as do the proposed bad actor disqualifications.”
An owner of a self-storage business in Missouri, David B Kolstedt, voiced his support for the SEC proposals in a Jan. 5 comment letter. He said he has three profitable locations and would consider expanding his business under a revised Regulation A offering.
The $50 million limit would allow him to add about a dozen properties, he said.
“We have already added three jobs to the economy within the limits of our own personal investment and could probably add five times that with additional investment,” he said. “If the JOBS Act is about adding jobs through a strengthened economy, then this is a win for the country and the company.”
To contact the reporter on this story: Che Odom in Washington at email@example.com
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The proposed Regulation A-Plus is available at http://www.sec.gov/rules/proposed/2013/33-9497.pdf.
Comment letters on the SEC's proposal are accessible from http://www.sec.gov/comments/s7-11-13/s71113.shtml.
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